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Equity Capital Remains on the Sideline

Real estate equity capital remains voluminous but the lack of debt financing, a mismatch between capital and available product, and desire to see a proven market bottom are contributing to dramatically lower transaction volumes in 2008. That was the message from a panel of experts assembled to discuss the state of commercial real estate equity capital markets in an event hosted by the Real Estate Investment Advisory Council. Still, the panel members expect the market to begin improving as these factors inevitably turn around, possibly in 2009.

The June meeting at the Westin Buckhead was moderated by Dale Taysom, a managing director of Prudential Real Estate Investors. Panelists included Neill Faucett, managing principal of Lubert-Adler Lubert-Adler Real Estate Funds; Bob DeWitt, president and CEO of The General Investment & Development Cos.; Seth Weintrob, a managing director with Morgan Stanley; and Ewoud Swaak, president of Westplan Investors.

The panel noted that equity capital earmarked for United States’ commercial real estate investment remains very deep and demands greater returns than in recent years. At the same time, mortgage money for acquisitions is pricier and less available, so more of the purchase price must be funded by comparatively expensive equity.

That math has led to falling buyer bid prices for available properties and given rise to the current "bid-ask spread," the gap between willing seller and buyer valuations. With no common ground on pricing, transaction volumes have slowed. Weintrob of Morgan Stanley noted that industry analysts have offered estimates of pricing contractions of 5% to 25%. Assuming prices might ultimately fall 10% to 15%, he says, the market may be half way there at present.

Cap rate increases have accounted for the initial declines, but net operating income underperformance will be the next driver, according to Weintrob. This is particularly the case with some high-profile office investments where rents were expected to dramatically increase before leases reset. Instead, far lower rent growth is now expected.

Another driver is the changing investment motivations of equity providers, according to the panel. Whereas low-risk, low-yield core capital was abundant in recent years, the equity sector targeting higher yield distressed investments is experiencing the greatest investor growth today.

DeWitt noted General Investment & Development Cos.’ long-term agreement to purchase apartments with core money on behalf of CalPERS. Those properties, he said, routinely trade at around an 8% internal rate of return (IRR). He added that the risk/reward of taking investment chances in this market argues for conservative underwriting, and thus his company has not purchased any apartments so far in 2008. The "denominator effect" partly explains the conservative investment stance of pension funds today, says DeWitt. Declines in the stock market and other asset classes have brought real estate allocations back in line without need to buy additional properties.

While the core marketplace has gone quiet, sponsors looking to acquire properties at artificially low, distressed prices have raised numerous funds. By taking advantage of perceived market dislocations, distressed investors are expecting 20% or better IRRs from their investments, according to the panel. Lenders are the anticipated source of most distressed product, which can be real estate owned (REO), loans in default or close to default, or even healthy loans of ailing lenders.

Lubert-Adler is looking for opportunities in all these areas, according to Neill Faucett. So far, for-sale residential land has accounted for most of the distressed investment opportunities and land pricing has not yet hit its bottom, according to the panel. Faucett said that some reports suggest as many as 65% of land acquisition-development loans could ultimately go bad. This will cause significant distress to some regional and local lenders where these loans make up 10% or more of balance sheets, and underlying bank capital is highly leveraged.

The panel also noted that Class-A property investments should outperform Class B and C properties, so understanding the different performance profiles of each asset class is important.

The desire to witness the bottoming of asset pricing before jumping in was a repeated theme among the panelists. Some funds require periodic reappraisals, and panelists like DeWitt said clients are reluctant to incur a downward revaluation on new investments. The more conservative approach, he says, is to wait until the recovery is well underway.

The panel also noted some bright spots. Faucett highlighted the positive impact on real estate investments of metro Atlanta's 150,000 net population gains annually and future job growth predictions. Taysom and Weintrob related experiences from recent trips to the Middle East to raise investment capital. Both expect more equity to flow into U.S. real estate from that region as Middle Eastern investors are willing to de-link U.S. subprime mortgage fallout from performance prospects of commercial real estate.

DeWitt pointed to the ailing single-family marketplace as one of several factors that will increase resident demand for apartments, setting the stage for property income increases. Swaak of Westplan Investors said that in-town luxury apartment development had represented the bulk of his company’s investments to date, although he recently raised a fund targeting distressed land. Swaak, who places Dutch private and institutional capital into U.S. investments, indicated that his investors continue to endorse U.S. real estate. All the panelists viewed apartments as the best performing property sector in the current market.

Still, Taysom said that Prudential has been active purchasing mezzanine positions versus the outright property ownership because his company is able to obtain projected mid- to high teen IRRs while remaining at comparatively safer positions in the capital stack.

The incongruous nature of the risk-adjusted returns appears a temporary phenomenon. Once the available logjam of distressed commercial mortgage paper and mezzanine positions clears the market, says Taysom, and mortgage lenders return from the sidelines, capital flows and return expectations should normalize and investment activity among the "four food groups" — office, apartments, retail, industrial — should begin improving. The panel said to look for that stabilization and recovery to begin sometime next year.